February 19, 2007

Real Estate: Myths and Exaggerations

Myth: Buying real estate will save you a lot of money on your income taxes.
Reality: Maybe

The interest that you pay on your mortgage and property taxes will save you money only to the extent that the interest, property taxes and your other itemized deductions exceeds the standard deduction you are eligible to take times your marginal income tax rate.

Example: Let's assume the Bush Cheney Average Joe family has a household income of $46,326 (median U.S. household income in 2005), putting them in the 15% marginal federal income tax bracket if they file married with a joint return. The Joes have their eye on a house like this 2500 sq. ft. beauty in Dallas listed on the market for $245,300 (median U.S. home price in 2006). The Joes put down a 20% down payment, leaving them with a $196,240 30-year mortgage and a total payment of $11,708.85 in interest in the first year of their mortgage. The Joes will pay another $4943.33 in property taxes. Assuming the Joes have no other deductions to itemize, their tax savings from buying this home is 15% x (11,708.85+4943.33-10,300) or $952.83. Not too shabby at all, but not exactly a bonanza either.

Some additional notes:
  • If the Joes can itemize additional deductions, their tax savings will go up even higher. Of course, additional deductions also means a greater risk of running into AMT country.
  • Another way the Joes can "save" more money on taxes is if they take out a bigger mortgage, allowing them to deduct the higher interest amounts. Of course, this begs the question of whether the Joes are actually saving any money if they are plowing their money into a bigger mortgage and, thus, bigger interest payments.
  • As the Joes' mortgage amortizes over time, the interest component of the mortgage payments will decrease. Assuming (1) property taxes increase 1% a year to go along with Dallas home appreciation, (2) no other deductions are taken and (3) the standard deduction for those filing married with a joint return increases 3.8% per year (as it did from 2006 to 2007) , the tax savings of owning decreases by about one-half after just 5 years and becomes non-existant after an additional 5 years.



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